Institutional investors are often viewed as informed traders, and individuals attempting to trade in the same market as institutions are likened to “tourists playing poker with professionals in the smoky backroom of a Las Vegas casino.”[1] So how do institutional investors gain their trading edge? By analyzing data based on public signals? By obtaining privileged information from connections? Or, is it just pure luck?

In our article, “Option Backdating Announcements and Information Advantage of Institutional Investors” (Journal of Accounting, Auditing, and Finance, in press 2018), we attempt to identify the source of institutional investors’ information advantage by analyzing their trading activities and performance around a unique corporate event that required firms to disclose adverse information unexpectedly, causing their stock prices to drop. This event is the stock-option backdating scandal, which was revealed in March 2006 when a Wall Street Journal article questioned whether executives retroactively dated stock-option grants to make them more valuable.[2] By the end of 2006, the newspaper had identified 136 firms as having admitted to backdating or disclosed backdating investigations by the Securities and Exchange Commissions (SEC) or the department of Justice (DOJ)

We use transaction-level fund trading data, and our research follows a two-step procedure. In the first step, we track the exact timing and execution price of trades made by individual funds before the public disclosure of stock option backdating investigations. We find that, on average, sample funds sell the implicated firms before the backdating announcements. Given that backdating announcements are unexpected events, our finding implies that these funds had preferential information about upcoming backdating announcements. However, the degree of advanced selling varies significantly across fund-firm pairs, indicating varying degrees of information advantage. Using these advance trades, we construct a proxy for information advantage at the fund-firm level and identify fund-firm pairs with a high degree of information advantage to establish pairs of interest.

There are several ways that informed traders might obtain information before the backdating revelation. One is diligent research about firm fundamentals. For example, traders might have used public data about a firm’s historical option grants to detect whether a firm engaged in backdating. Another way is access to corporate insiders. After all, developing relationships with company management is “a critical part of research they [traders] do when they evaluate which firms to invest in or bet against”.[3] An interesting characteristic of the backdating event is that some firms revealed the investigations themselves, while other firms waited for SEC or DOJ announcements. Based on this characteristic, we classify the implicated firms into “internal group” and “external group,” respectively. We find that, prior to the announcement of a backdating investigation, institutions sold stocks of the internal group more intensively, as measured by the buy-sell order imbalance and our newly proposed proxy that captures both timing and volume of institutional trades. This indicates that institutions probably get their information from the implicated firms.

To test whether institutional investors’ information advantage persists, the second step of our analysis focuses on the trading of these fund-firm pairs of interest at times otherthan the backdating revelation. We find that funds are more likely to make correct trades before the earnings announcements of their paired firms and that their trading performance is better for their paired firms in general. These results suggest that funds anticipate changes of the fundamentals of some specific firms with which they are connected.

Furthermore, we show that funds’ superior performance with respect to the internal group is most evident in the pre-backdating scandal period and disappears in the post-scandal period These results are consistent with the conclusion that following a backdating revelation, firms improve corporate governance, thereby pressuring corporate insiders to disclose information and reduce institutional investors’ advantage.

Our research makes several contributions. First, using transaction-level trading data, we show that some institutional investors persistently make astute trades for certain firms, probably because they receive inside information. Second, the fund-firm connection measure we develop captures a fund’s aggregate information advantage relative to a traded firm from all possible information channels; hence, it provides a powerful test to detect informed trading. In addition, while some researchers suggest that analysts and managers have incentives to convey positive news about the firm, we provide new evidence suggesting that there is a flow of negative news, conveyed either intentionally or unintentionally, between closely connected institutions and firms.

A caveat of our study is that our evidence on information leaks is circumstantial. In the real world, institutions and company management can establish connections through various networks (e.g., social ties, education networks, etc.). It is challenging, if not impossible, to identify the exact routes of information transmission. It is not our goal to assess whether insiders in the network leak price-sensitive information deliberately. Our research merely aims to offer new evidence that closely connected fund-firm pairs are more likely to divulge non-public, market-moving information.

This post comes to us from professors Wenli Huang of Hong Kong Polytechnic University, Hai Lu of the University of Toronto’s Rotman School of Management, and Xiaolu Wang of Iowa State University. It is based on the recent article, “Option Backdating Announcements and Information Advantage of Institutional Investors,” available here.